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In an eight-minute speech delivered at the foothills of Wyoming’s Rocky Mountains in late August, Jay Powell sought to stamp out lingering doubt about the US central bank’s commitment to fighting the worst inflation in decades.
Invoking the legacy of Paul Volcker — his predecessor who vanquished inflation in the 1980s — the sitting chair vowed the Federal Reserve would “keep at it” until it got price pressures under control.
But two months on, what exactly “it” will take is still far from obvious. There remain colossal unknowns about just how quickly inflation will moderate, the extent of the job losses as the central bank cools the economy, and whether the financial system can digest such a rapid surge in borrowing costs.
For the Fed, this lack of certainty has kicked off a fulsome debate about its tactics and how it will know when it has done enough.
“We definitely are moving into a new phase, and the messaging is a lot trickier,” says Julia Coronado, a former Fed economist who now runs MacroPolicy Perspectives. “It’s one thing to be starting from zero and playing catch-up . . . it’s another to be in the territory where you’re clearly closer to a restrictive stance and the economy and global markets are responding.”
So far this year, the Federal Open Market Committee has ratcheted up its policy rate from near zero to 3 per cent, hastily moving in 0.75 percentage point increments at its past three meetings in what has become one of the most aggressive campaigns to tighten monetary policy in its 109-year history. To augment its efforts, it has also begun shrinking its nearly $9tn balance sheet.
The FOMC is set to implement its fourth straight jumbo rate rise next week and signal further increases to come, six days before elections that risk fracturing Democrats’ control of the legislative branch and fundamentally reshaping the scope of what Joe Biden can accomplish in the second half of his presidential term.
His popularity pummelled by rising prices and recession fears, Biden has encouraged the Fed to use its tools as his administration affirms inflation is its “top economic priority”.
But as the spectre of a severe economic contraction looms, the Fed’s detractors have sharpened their criticism. Democrats are warning the central bank risks jeopardising millions of Americans as it tips the economy into recession. A growing cohort of economists warn against an overcorrection, highlighting the risk of moving too quickly and breaking something.
The Fed’s strategic direction has enormous global repercussions, not just for the range of central banks who take their cues from the US on fighting inflation, but also for the indebted developing economies staring at potential defaults as the US dollar surges.
“[The Federal Reserve is] in an incredibly difficult spot,” says Daleep Singh, who previously led the markets group at the New York Fed before serving as deputy director of Biden’s National Economic Council. “Really every central banker all over the world is feeling nervous, anxious and fearful that they might lose decades of hard-earned inflation-fighting credibility.”
Under the hood of the economy
On the surface, the US economy shows some signs of strength. But with relentless inflation and high borrowing costs starting to bite, cracks have emerged.
The labour market continues to make notable gains. Thus far in 2022, 420,000 positions have been added on average each month, down from 562,000 last year but still well above what economists consider sustainable. The unemployment rate, meanwhile, stands at the pre-pandemic low of 3.5 per cent.
Despite nascent signs of loosening, the jobs market is still among the tightest in history. For every unemployed person, there are still nearly two vacancies. In many states across the country, there are three. To overcome this, employers have had to rapidly boost pay, with the pace only recently starting to ebb.
But wage bumps have largely been outpaced by inflation, which is now running at an annual rate of 8.2 per cent. Worryingly, “core” measures, which strip out volatile items like food and energy and include categories like services and housing-related costs, keep accelerating, suggesting price pressures are becoming harder to root out.
Any residual optimism about the economy has been overshadowed by the intensity of the price shocks. While gross domestic product growth rebounded in the third quarter after shrinking in the first half of the year, there are clear signs that consumer demand is weakening.
US business activity has also already taken a hit, contracting in October for a fourth-straight month as manufacturers and services providers became increasingly downbeat. That has helped to ease supply logjams, pushing shipping costs lower.
Centre stage is the housing market, which is buckling as 30-year mortgage rates this week eclipsed 7 per cent, the highest since 2002. Prices nationwide have collapsed, but the declines have been largest in cities that experienced the biggest booms since the start of the pandemic.
Economists expect fractures to become even more apparent as the effects of the Fed’s tightening campaign start to amplify. Policy adjustments take time to filter through the economy, and show up in the data long after the damage has been done.
This lag means that the bulk of the Fed’s actions to date — which have triggered a substantial appreciation of the dollar and damped demand for risky assets — have yet to fully materialise.
It also highlights the costs of the Fed’s slow reaction to inflation it initially thought was “transitory”.
“The Fed greatly complicated its task by waiting to begin interest rate increases until March,” says Randal Quarles, the Fed’s former vice-chair for supervision who left in late 2021 and supported rates rising last fall. “Had we done that, given the lags of monetary policy, we’d already be able to see what the effects were of those interest rate increases.”
The case for slowing down
Many now believe inflation has peaked and that a recession is likely next year, igniting a discussion both internally at the Fed and externally about how much more it should squeeze the economy.
Top officials have indicated greater concern about doing too little rather than too much, harkening back to errors made in the 1970s that sowed the seeds for rampant inflation. To ward off a redux, the Fed has said it will wait for substantive signs that inflation is falling back towards its 2 per cent target before pausing rate increases.
But the pace at which it is moving makes some queasy. “Every additional 75 [basis point increase] makes me feel like the plane is going to crash rather than land smoothly,” says Ellen Meade, a senior adviser to the central bank’s board of governors until 2021. “There’s a reason for going a little bit more slowly, and that’s to watch and to react to the effects your policy is having. At this rapid clip, they aren’t doing themselves any favours.”
Some Fed officials have already begun to lay the groundwork for smaller rate rises, as Canada’s central bank did this week and Australia’s did earlier this month. “The time is now to start planning for stepping down”, San Francisco Fed president Mary Daly said last week.
December could mark a downshift to half-point increments, but that depends on jobs and inflation data due beforehand. There is also not yet a clear consensus among policymakers, with some worrying about being wrongfooted by faulty forecasts that inflation is moderating.
If they did scale back, officials might move to lift next year’s projection for the benchmark rate beyond the 4.6 per cent median level previously pencilled in, to guard against investors again prematurely pricing in a pivot away from tight policy. Fed funds futures markets now point to it peaking at about 5 per cent.
As the Fed ploughs ahead, heavy-handed political pressure is only set to intensify. Senate Democrats have already stepped up their rebukes, with Sherrod Brown, chair of the Senate banking committee, and John Hickenlooper of Colorado this week joining Senator Elizabeth Warren of Massachusetts and Vermont’s Bernie Sanders in urging the central bank to reconsider its plans.
Their concern is jobs. Most Fed officials project the unemployment rate to rise to 4.4 per cent, but many Wall Street and academic economists believe that forecast is far too optimistic.
Deutsche Bank reckons getting inflation back to target will require unemployment breaching 5.5 per cent. Laurence Ball at Johns Hopkins University argues a more realistic estimate is upwards of 7 per cent.
Such substantive job losses, and the recession they would bring, would cause most pain to those least able to weather it, reversing most if not all of the gains accrued in the post-pandemic recovery.
“One of the very unfortunate truths of the current situation is that the people who are really suffering right now from high inflation — low-income households — are also the people who are going to bear the brunt of the tightening,” says Stephanie Aaronson, a former Fed staffer now at the Brookings Institution. “This is a no-win situation.”
Straight talk
Yet another fear is a financial accident that threatens the stability of the broader system.
“We are still the 800-pound gorilla in the international economy, and in the financial part of that, we are the 8,000-pound gorilla,” says Alan Blinder, who served as the Fed’s vice-chair in the 1990s.
Most vulnerable are highly-indebted emerging and developing economies being hammered by the strength of the dollar and rapidly rising borrowing costs. With 60 per cent of low-income countries at or near debt distress, there “inevitably” will be defaults, the head of the IMF warned last month.
Angst is also growing in Europe, which is staring down an acute energy crisis linked to the Ukraine war. Even as the economy teeters on the brink of recession, the European Central Bank again this week followed in the Fed’s footsteps and raised rates by 0.75 percentage points to combat soaring costs.
The blowback to the US from events abroad is small, Blinder notes, but he acknowledges it is “not zero”.
The turmoil in the UK financial markets last month, while stemming from political missteps, offered a cautionary tale about how unforeseen events can quickly spiral and demand costly interventions. “You don’t want to be in the Bank of England’s shoes,” says Coronado.
Amplifying concerns is the fragility of the $24tn market for US government debt, the foundation of the global financial system. Trading conditions have rarely been choppier and liquidity now hovers at levels last seen during the March 2020 meltdown.
Back then, the Fed stepped in to ensure dislocations there did not set off a full-blown crisis. This time, the Treasury is discussing buying back some of its bonds to improve liquidity, despite maintaining that the market on the whole is functioning.
Such a policy would require clear communication that these interventions are purely about the health of the market and do not convey “any signal about the appropriate stance of [the Fed’s] policy”, says Singh, now at PGIM Fixed Income.
Straight talk from the Fed will also be crucial in the coming months, other former officials say, especially as views splinter internally.
Quarles warns that the biggest challenge for the Fed, probably arising in the first quarter of 2023, will be overcoming a potential “fracturing of the message” as the data become less clear-cut.
For Andrew Levin, a two-decade Fed veteran, what is most critical at this stage is for the central bank to be upfront about the pain forthcoming.
“It owes it to the public to explain like a team of physicians and say, ‘this is a very serious illness, we’re going to have to take you into surgery and it’s going to be a slow recovery, but we think that this is essential to restore your health’,,” he says.
Additional reporting by Caitlin Gilbert in New York
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